What is in the stimulus package?
The government of China has recently announced a new stimulus package that includes a 0.5% cut in bank reserve requirements (with the exception of small banks), cuts to key interest rates and central government loans to local authorities to buy up unsold real estate assets, and a reduction of the capital required to buy a second home from 25% to 15%. In addition, the People’s Bank of China (PBoC) will provide 800 billion yuan (around USD 113 billion) of liquidity to stabilise the equity market.
The measures were just announced, and further policy decisions are expected. On the face of it, these stimulus measures will help to contain a further worsening of the balance sheet recession and deflationary pressures affecting the Chinese economy. In particular, they will support asset prices. On the other hand, they will not trigger a new credit cycle in the private sector, for either companies or households. We know this from the lessons learned in Japan, where the private sector went into a combined savings surplus in the mid-1990s, and where zero or even negative interest rates never helped to rekindle demand for credit from the private sector, forcing the government to accept large, recurrent deficits that caused public debt to explode to over 250% of gross domestic product (GDP).
The Chinese authorities are therefore relieving deflationary pressures but will certainly not reverse them. This is thus a step in the right direction, but it needs to be accompanied by a new fiscal policy of transfers from public to over-indebted private balance sheets. We know that this is a politically sensitive issue, since we are talking about relieving the losses of the strata of the population that have benefited the most from the growth of the last three decades in China, while hundreds of millions of Chinese are still living very modestly but do not have problems of overindebtedness and loss of wealth.
How will this affect Chinese equities?
Between 2021 and 2024, i.e. in three-and-a-half years, Chinese equities lost -47% (CSI 300 Index). For the record, this is around the same fall in about the same time frame as those recorded by the Chinese market in 2009–2013 and again in 2015–2019. The market bottom in February of this year marked the start of a cyclical bull market. Unlike the previous two bull markets, which lasted around two years and saw the index rise by around 150%, this time the recovery is likely to be more modest against the backdrop of a balance sheet recession, which occurs when high levels of private sector debt cause individuals or companies to collectively focus on saving by paying down debt rather than spending or investing, causing economic growth to slow or decline.
Complementing the soft landing scenario of the US economy
More generally, this announcement of stimulus in China ideally complements the overall macroeconomic scenario of a soft landing for the US economy. The US labour market has cooled – a little too much, according to some – and inflation has normalised towards 2%. The problem is that this scenario is fully reflected in the valuations of the major asset classes, US Treasuries and German government bonds (Bunds), corporate bonds, and developed equities. Moreover, all is going well in the best of all possible worlds, with Western central banks normalising interest rates, confident that inflation is anchored to their target of around 2%. Even the Fed’s surprise decision to cut rates by 50 basis points (bps) did not arouse the slightest concern, such as ‘what they may know that we do not’. This was reflected in the reaction of US long rates and equity markets at the end of last week. We were expecting a 25bps cut.
When I was asked on Bloomberg TV on Thursday morning why the Federal Open Market Committee (FOMC) had cut rates by 50bps the previous day, my best guess was that the committee wanted to anticipate somewhat – in view of the proximity of the US presidential election on 5 November, since its next meeting will take place on 6 and 7 November. The other explanation is that the increases in key rates have dramatically affected the cost of servicing the public debt in the United States, and there is an urgent need to give the US Treasury some room to breathe. We leave it to you to choose the most likely explanation.
Europe’s dire situation will not be solved
As you know, we tend to treat asset valuation as an outcome rather than a decision factor most of the time. Indeed, valuation only becomes important in investment decisions when it becomes provocative and controversial, i.e. either very cheap or very expensive. Even if we have little direct exposure, we are inevitably indirectly exposed in the rest of our portfolios. We have already seen this, since the most exposed sectors (e.g. the European automotive industry and the luxury goods sector) have recently seen their valuations squeezed as a result of the deterioration in the Chinese economy. These sectors should bounce back in the short term, even though the problems of the European automotive industry are deeply structural and will not be solved by a temporary upturn in Chinese domestic demand.
In contrast to the US, Europe is in a dire situation, and the chances that any of the necessary remedies for its structural ills will be implemented are slim. In this context, it is quite striking to observe the intensity of the debate on the normalisation of Federal Reserve (Fed) rates while the European Central Bank (ECB) is stubbornly preoccupying itself with inflation. In the meantime, despite the short-term boost from Chinese stimulus measures, European assets remain unattractive, with the exception of large-cap companies boosted by global factors and the global cycle.
Now is the time to be reasonable in our positioning
It is striking that the valuations of the major asset classes reflect such confidence in the future at a time when the conflict in the Middle East is worsening by the day and we are less than two months away from such an uncertain US presidential election. So now is the time to be reasonable in our positioning. On the one hand, we still see no reason to question the market’s primary uptrend, which dates back to October 2022. On the other hand, the short-term risk/return outlook remains relatively poor, with the S&P 500 trading at current levels.